Why Bother with Stocks?
Recently, I was preparing a presentation about why one should invest in bonds. As I was doing so, it struck me that no one has ever asked me why they should invest in the equity market. It seems that a good portion of the public simply take it for granted that they should invest in stocks.
But it can be risky, right? You can lose your investment. Seriously, why bother with stocks?
Part of the reason is very basic: inflation. I am not being trendy. I am not referring to tariffs or the Strait of Hormuz. Here is a simple thought exercise:
You live in a fantasy world of no inflation. Let’s assume that your annual salary today is a cool $100,000 and this buys you a lifestyle that you like. So, when you retire in 30 years, you would like to have the same income available to you. You expect Social Security to pick up half of that, so what you are aiming for is to have enough savings to generate about $50,000 a year.
Conventionally, to generate $50,000 a year reliably, you need a nest egg of $1.25 million.[1] Starting today you resolve to sock away about $3000 a month in your bank savings account. The bank pays a wee bit of interest; let’s say 1% to keep the example simple. Through the magic of compound interest, you end up with your desired nest egg 30 years from now and live happily ever after.
Already we face the very obvious problem that saving $3000 a month, our non-inflation fantasy world goal, is more than a third of our hypothetical monthly gross income. That could be difficult to sustain consistently over a long period. Life (houses, children, health) has a way of getting in the way.
But here’s another problem: we don’t live in a fantasy world of no inflation. Over the last 20 years, the average change in the Consumer Price Index (CPI) is 2.57%. What $100,000 buys today will require more than $200,000 thirty years hence. If we continue to assume that Social Security will pick up half the load, then instead of needing a $1.25 million nest egg, $2.7 million is needed. That’s tough sledding with a bank account paying just 1%. You would have to save an unreasonable $6500 monthly!
You need an investment that will generate a return that will not only outpace inflation but also is likely to generate enough of a return that you don’t have to make a choice each month between eating and investing.
Which brings us to the stock market. You’ve heard it 1000 times, but you need to hear it again. Past performance is no guarantee of future returns. Nevertheless, the US stock market has averaged more than a 10% annual return over the last 30 years. (Of course, this average has been pulled up by the bull run of the last decade!)
I know what the next question is. Having sold you on the importance of the stock market, why would you even bother with bonds which don’t usually yield as much? Well, here’s why. The path to an average 10% stock market return does not run smoothly. (Have you already forgotten the 19% plunge in the S&P 500 in 2022?) And depending on where you are on your 30-year saving journey, you may not be (nor should you be) comfortable with the ride.
That’s why when I am charting out how much a client should save for retirement, my reference point is not the S&P historical average, but the 10-year trailing annualized return of a balanced portfolio of 60% stocks and 40% bonds. (And then I give that figure a bit of haircut to account for the overperformance of the market in the last 10 years.) The good news is that over very long periods of time, historically the average return for a blended portfolio has only been a smidge lower than an all-stock portfolio, but without the drama.
At various times, and with varying interpretations, professional investors will talk about the TINA (There Is No Alternative) trade. Despite its warts, there is no reasonable alternative to investing at least some of your savings in stocks for your retirement account during your “accumulation years.” Your task is to go into the trade with a clear understanding of the risks, arriving at a portfolio allocation to stocks that reflects not just your timeline but how you respond emotionally to investment risk.
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[1] I am employing the well-trod 4% “rule” which works well enough for this purpose.